Nouriel Roubini has officially left the “hedging your bets on the economy” camp. He has declared the markets to be frothy because super low dollar borrowing rates have turned the greenback into the funding currency for the carry trade.

Far more important than the peppy rally in the stock market is the resumption of early 2007 style risk taking in the credit markets. As Gillian Tett of the Financial Times noted last week:

Earlier this month, I received a sobering e-mail from a senior, recently-retired banker. This particular man, a veteran of the credit world, had just chatted with ex-colleagues who are still in the markets – and was feeling deeply shocked.

“Forget about the events of the past 12 months … the punters are back punting as aggressively as ever,” he wrote. “Highly leveraged short-term trades are back in vogue as players … jostle to load up on everything from Reits [real estate investment trusts] and commercial property, commodities, emerging markets and regular stocks and bonds.

“Oh, I am sure the banks’ public relations people will talk about the subdued atmosphere in banking, but don’t you believe it,” he continued bitterly, noting that when money is virtually free – or, at least, at 0.5 per cent – traders feel stupid if they don’t leverage up.

“Any sense of control is being chucked out of the window. After the dotcom boom and bust it took a good few years for the market to get its collective mojo back [but] this time it has taken just a few months,” he added. He finished with a despairing question: “Was October 2008 just a dress rehearsal for the crash when this latest bubble bursts?”

In other words, everyone seems to be in on this bubble except most borrowers in the real economy. But that wasn’t the main objective…it was to reflate asset prices to save the global banking system…by rerunning the same movie that drove it off the cliff in the first place (well, this is a sequel, so there are some minor plot changes, like the dollar rather than the yen as the basis for the carry trade).

Since March there has been a massive rally in all sorts of risky assets… and an even bigger rally in emerging market asset classes (their stocks, bonds and currencies). At the same time, the dollar has weakened sharply, while government bond yields have gently increased but stayed low and stable.

This recovery in risky assets is in part driven by better economic fundamentals…. Whether the recovery is V-shaped, as consensus believes, or U-shaped and anaemic as I have argued, asset prices should be moving gradually higher.

But while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally….Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.

People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.

Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage- backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low.

So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

While this policy feeds the global asset bubble it is also feeding a new US asset bubble….

The reckless US policy that is feeding these carry trades is forcing other countries to follow its easy monetary policy….This is keeping short-term rates lower than is desirable. Central banks may also be forced to lower interest rates through domestic open market operations. Some central banks, concerned about the hot money driving up their currencies, as in Brazil, are imposing controls on capital inflows. Either way, the carry trade bubble will get worse: if there is no forex intervention and foreign currencies appreciate, the negative borrowing cost of the carry trade becomes more negative. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies. So the perfectly correlated bubble across all global asset classes gets bigger by the day.

But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.

This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.

A joke making the rounds among stock investors is that they’ve all become currency traders. In recent weeks, the relationship between moves in the dollar and stocks has been incredibly tight; as the dollar rises, stocks fall and vice versa.

And it isn’t just stocks. Links between the dollar, corporate bonds, energy prices and gold have grown closer. Traders and analysts point to one factor as the cause: the Federal Reserve’s efforts to flood the financial markets with dollars. They say the Fed has created an unusual environment where investors essentially have two choices — hold onto dollars or buy something, anything else.

The connections between assets have been growing as investors become more fixated on how and when the Fed will turn off the spigot.

The intensity of the links “tells me there is a lot of nervousness and a lot of fast money,” says Michael O’Rourke, a market strategist at BTIG.

As a result, some believe the markets are in a new bubble, driven by interest rates essentially at zero, which will pop sooner rather than later. That camp includes Pimco’s Bill Gross, who last week wrote that the six-month rally in riskier assets, spurred on by the Fed and U.S. Treasury, “is likely at its pinnacle.”

46 comments

I know you said this tongue-in-cheek, but some of the crises he’s predicted have come; and some of the crises he’s predicted have not. He and Setser were warning of currency crises and other disasters that never really occurred(but were logical possibilities). I think we culturally place too much emphasis on track record and stature, and too little on sound reasoning.

As an aside, I was stunned and saddened by Setser’s decision to join this Treasury team. I can’t believe he thought he could make a difference; maybe he felt like he owed Geithner one. Seeing the same old ugly imbalances being deliberately fostered must be driving the guy nuts.

I suspect he was more influential and useful on the outside of the machine peering in. But I’ll never know, because I’ll never be in there. :D

I have been a critic of Roubini and his going “soft”. What he is saying here is mostly correct. It is also what we have been saying around here for 6 months. I don’t know what that says about his prescience. The credit lines and massive injections by the Fed and Treasury without any real strings attached to the banksters, the gamers of the system, were bound to go the way we have seen them go. The bubbles in stocks and commodities without any positive trending fundamentals to explain their rises has been there for all to see. Yes, they are bubbles and yes, they will burst as all bubbles do. I always find it a bit strange, this idea of validation, that an idea only takes on weight when an officially sanctioned mover and/or shaker gives it their imprimatur no matter how far behind the curve they have been.

Others know more about the currency situation than I, but if you look from the beginning of the year to now, the dollar is down about 6% against the euro, about twice that with regard to the pound and steady against both the yen and yuan. So I can’t help but think some of the negative rates Roubini is pointing to are overblown.

We’re seeing yet again how these speculator parasites are existentially the problem. Many of us have pointed this out from the start.

Currency manipulation and commodity speculation are simply crimes which have no place in a human world, and the fact that they’re not only allowed to exist at all but so obscenely rewarded, the proceeds of massive corporatist looting and TBTF extortion, shows how far we’ve fallen from ruling ourselves according to any human ideal.

They are absolutely incorrigible; you cannot rehabilitate them. Everything they do creates zero value, but is purely reckless, destructive, parasitic, predatory. They will continue to prey upon all of us until we get rid of them completely.

Here here attempter! You point out precisely what I feel needs to be addressed. The wheels are off, the “experts” egotists seldom right, the fundamentals of economics need a very good going over and meanwhile we’re discussing how many dollars can dance on the head of a pin, and at what rate of inflation or deflation!

Money does not make the world go around. We are grinding to a halt here people; top soil erosion, diminishing clean sources of water, air pollution etc. Just how much more important than everything else is money? Will we let civilization go to pot because we don’t have enough money to fix it?

Sorry to be so emotional, but these are times where emotions can, and probably should get aroused. Fuck the experts! How often do they have to be wrong before we chuck them out on their ear?

I’m amazed any of these statements is contentious. I think it’s patently obvious, even to those participating in the new asset bubbles. But we should still ask the question of what could prove Roubini wrong here. To me, there are two possibilities: serious global growth, or serious inflation in goods and services.

Both global growth and inflation in goods and services would require consumer or end user demand to pick up somewhere. But transmission from asset prices to the real economy just looks really broken at this point. Wealth effects are kicking in a little for the bourgeoisie, and we’ve triggered another round of investment, but the financial accelerator is stuck in fifth gear and final demand is going nowhere.

We did have decent PCE in the last GDP report — which shocked me, and will provide a longer-term detriment, given falling wages — but no other country is stepping up with any demand other than G and I. China and Korea in particular are booming with additional investment in additional overcapacity. That’s going to further hamper extremely low existing capacity utilization, adding to deflationary pressures in the medium term.

I’ve been stubbornly adamant that there are no Keynesian multipliers from government spending, and I believe this performance bolsters my case. All in all, the global economy is becoming more imbalanced in the same ways that caused the last explosion by the day. I see no reason to expect a different outcome.

Good on Roubini for pointing out the intellectual bankruptcy of our clearly. It won’t alter policy, but he’ll have another “I told you so” at some point.

Gam zeh yaavor — but anyone know how to say, “this, too, shall pop” in Hebrew? Bernanke? Full disclosure, I still sit entirely in Treasuries.

“This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while.”

Well I’m thick and economically illiterate compared to Roubini, but I most certainly would not have the nerve to come up with this drivel. What’s the point of “a while”? We’ll all be dead in a while. Big deal.

I think this is worth exploring a bit more and suspect Roubini has stopped short of the consequences. Firstly investors borrowing to invest abroad would tend to crowd out lending for domestic purposes which will curtail demand in the US. Take into account rising asset prices slowly feeding through to margins and eventually prices and things don’t look to rosy for the real economy. Brad Setser I am sure would point us to the flow of money out of the US and the consequences to the trade balance of payments. Here we should expect those reserves in emerging economies to be ballooning as a result, but there is some evidence that diversification is limiting the impact. Still this should support treasury issuance.
Any potential unwind might have more than one phase. Initially demand for dollars will go through the roof as loans are repaid. The worry here is that there will be lots of defaults as well hitting US banks profitability. As money flows reverse and the dollar climbs you can expect big impacts on international companies as their dollar hedging strategies go haywire. This will most likely affect profits and since exports could also be hindered this ought to be reflected in an equity decline. Short term treasuries will rally and their yields fall although as time progresses lack of external demand will begin to turn this round. What you end up with is a stupendous dollar rally followed by a lesser dollar crash and extreme dollar volatility. Through each phase the real economy gets more damaged and the reserve status of the dollar becomes more and more eroded. My feeling is that after a period of a few years you end up with a dollar valuation somewhat down from where it is today.

Assume the impossible. The Fed raises the funds rate to 2%. I would think that this would cause a sharp dollar correction, but just for a few days. It will not reverse what is happening. As a reserve currency the dollar is a ‘Store of Wealth’. It is doing a terrible job at that.

All my life I have been told, “If you want to make big money you have to do it using another person’ money”. The folks doing the carry trade aren’t crooks. They are investors looking to make a buck. If the government hands them the mother of all carry trades they will take advantage of it. And bubbles will follow. We know what happens to bubbles. We just don’t know the timing of it.

I see a carry trade that is widely pursued and which at some point will unwind, more probably, implode.

I know of no currency that is redeemable in gold or silver. I know of no currency whose issuance is determined by reserves of gold or silver. The world is floating on a sea of fiat currencies. This is a situation that cannot continue forever.

I see it as being impossible for the fiat dollar, or any fiat currency, to function as a ‘Store Wealth’.

Given the Fed induced artificially low Treasury paper rates, the rational trade is a carry trade. The folks who are doing the carry trade are not entirely a bunch of crooks. It is true that among them there are, indeed, fraudsters; but the causative force is the interference by the Fed, the Treasury, the Congress and the Administration in the establishment of the primary price, the term schedule of interest rates.

Money and banking are the nexus of economic activity. We tend to differentiate the finance sector from the production-consumption sectors by calling them the ‘real economy’. That appellation implies that finance is not at all related to economic activity when it is, in fact, the intermediary of all economic activity.

It is our money and banking system that is disfunctional. It urgently needs correcting. Particular attention needs to be given to establishing the dollar as a store of value, that implies specified backing by gold and/or silver.

The concept of fractional reserves needs to be examined in that the imbalances manifest in this great recession are rooted in a bed of profligate debt that is ultimately funded out of demand deposit liabilities. I often wonder, who is the greater criminal, the one who cheats; or the regulators who says that the market will appropriately redress the cheat?

Roubini’s observation needs to be heeded, not parsed into meaningless arguments as to dates certain or effects absolute. Lets not quibble as to whether Professor Roubini has it absolutely right, lets focus on why Professor Roubini’s observations require consideration.

From apologist Roubini in FT, like Galbraith, so afraid to bite the hand that feeds and nail the scum to the wall;

“This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.”

The Bubble Clowns

Forgive them father,
For they know not what they do,
The fed and the policy makers,
Are such an ignorant crew,

They have no knowledge,
Of how to blow bubbles,
To intentionally create,
Geopolitical troubles,

They are unaware,
Of global consumption,
And could not control it,
At least that’s the assumption,

But bubbles can take you up,
And bubbles can take you down,
They can fund sustainable growth,
Or they can make consumption drown,

And the bubble machine is never blind,
Especially when controlled by deception,
The monster bubbles will only end,
When the marks increase their perception …

“So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.”

Not that I know anything, but if seems to me to be business as usual for the Fed, which has believed for about 25 or so years that every problem can be solved by low interest rates, and problems caused by low interest rates by lower interest rates.
A lot of life, and all of finance has to do with balance. At some point the Fed lost the nerve to take away the punch bowl – now its party, party party. Hangover?!!? MORE PUNCH. The only question is: how far away is liver failure.

I guess the only difference between this asset inflation and previous is that this time we get multiple bubble-etts – stocks for a while, then bonds, then dollars, then Fx, then commodities, then metals, then whatever. Its a waiting game while the banks write-off 1 loan a week and take 4 months to fund a government-guaranteed refinance.

At this rate, we won’t have a lost decade, we are going have a lost century.

Bernanke is a true Keynesian, he understands that in the long run we are all dead.

Can someone please explain what a “carry trade” is? I looked it up, but something is getting lost in translation. Thank you.

The general decription, Brad, is borrowing cheap and short to invest in something longer and higher yielding.

Because we have a tacit guarantee from the Fed that dollars will remain plentiful and essentially free for the forseeable future, investors feel like it’s a very safe bet to borrow as much as they want in dollars. This money can be invested basically anywhere, because most anything should deliver a higher return than 0% in a currency of a country with massive structural deficits. These trades are done with serious leverage, and lead to assets of all stripes being bid up and the dollar being sold down.

Eventually, the Fed will have to raise interest rates, or the asset bubbles will reach such dizzying heights that something snaps and one or more of them collapse. At that point, the carry trade will need to be unwound: players will need to sell everything they’ve bought to repay the dollars they’ve borrowed. That process will be spectacular when it comes.

Bucky don’t need to appreciate quickly. The elephants in the door of the crowded theatre on fire will push the price up, just as they pushed it down. The dollar is the key to debt leverage around the world and the inflation of the trade requires more dollars. They are kind of like bricks in a wall.

I think Roubini has been pretty well right on for a mainstreamer. The rally in the dollar last year ripped some heads off and people seemed to think it was a false echo, like some view the bear move in stocks in light of this recent rally. If you think we didn’t have a currency crisis last year, then why has the Fed flooded the market with dollars for banks to exchange between each other? Do you really think they took all those actions to get the LIBOR down merely because they didn’t like the rate? The trade is much larger today and it has been influenced by the most devalued of all areas, China. No one has inflated like China and most of it has gone into speculative, rather than real expansive avenues. There isn’t going to be a continued rebound as long as the US keeps shedding 2 million jobs a month.

I don’t believe most people understand the destruction of credit on the margin. There are only so many people that will wade up to their neck in debt and become debt slaves. People are getting smart, at least in the sense that I don’t believe they are going to give the speculators an easy out on this one. The weight of crushing debt is going to put pressure on any anti-dollar trade for some time to come.

Yes, let’s play. Is Goldman only half the US portion of this little party, or more? How much is the cloud of hedge funds investing Harvard’s endowment and your state employee pension fund (don’t worry, just 10-er, 20- er, maybe we don’t know what percent this quarter as we’re trying to catch up you see)? And how much is the rest of the global FastCash wrecking crew?

Or, are Vanguard and the 401(k) convoy sailing over the edge of the world too? How about the insurance and pension funds in general?

Again, we’re in MegaJapanese mode so if you are not in on this leveraged bubble you are, of necessity, resigned to low to negative returns on all asset classes. I for one just don’t think most of the money junkies in our society can handle that truth.

So my bet would be that, once again, a surprising amount of ‘safe as houses’ money is about to be bonfired.

Rosie remarked there was a “remote” possibility of a change in the language of the FOMC statement on Wed, that the Fed might remove the words “extended period” with regard to fed funds rates.

Shortly after than email the Oct ISM report showed an expansion in the employment index. This on top of the fact that the banksters are awarding themselves record bonuses in 2009 because of the low cost of borrowing available to them and a steep yield curve with which to hoard treasuries till the cows come home.

Now, up til now, Bernanke has been a mirror image of Greenspan’s reckless policies. Ben has a chance to step up to the plate and telegraph a shift in policy towards tightening. Now if that were to happen, just freaking maybe, some traders might become a bit more circumspect, well maybe for a few flipping days. The expansion in the ISM employment index carries upside risks to the economists forecasts for the Oct NFP on Friday.

The short term trades are getting interesting with these dynamics heating up. But, as for the “mother of all carry trade unwinds” – that can is gonna have to get kicked down the road – probably sometime well into 2010.

I am trying to write up the meeting, but I am too tired to finish tonight, I had to get up early and am fried.

It was peculiar. We basically talked past each other. They acted like they were answering our questions but the three I had drinks with afterwards were as unconvinced and unsatisfied as I was. These were all standard moves, I’m sure they’ve been over largely the same ground with other people, so they have already perfected their answers on a lot of topics, they are very good at Teflon.

BTW the one thing I will give them credit for is this was almost entirely a discussion, not much in the way of presentation.

I wish that we had “naked capitalism”,then we wouldn’t be stuck paying for the stupid decisions and investments of the banks.
Only our government representatives(who didn’t represent us)could allow huge transfers of money from the government to influential corporations and unions(GM).
When you consider that the “community reinvestment act” forced banks to make loans to deadbeats and Fannie and Freddie getting into the private markets,what we ended up with is naked facism.
“Capitalism” had the least amount of culpability in this collapse.

Roubini acts like Japan’s carry trade lasted a week. It lasted 15 years and is still unwinding. The day the USD stops and reverses for good is the day we see GOLD placed under it. That may never happen.As the now set price by the FED is $24. LOL!!! Although if it does( GOLD will be re-priced higher) then it will be good for GOLD either way as the reversal in GOLD in the 80’s will never happen again.The China bashing goes on while they buy the world with USDollars.It’s a 100 year plan. It’ isn’t going to end for many lifetimes because it has been planned for a very long time.

So let me get this right, if this whole unwinding occurs, we have deflation, so one should put his money in dollars. But what would you expect to happen after this unwinding occurs, and after the dollar regains its strength? (will dollar strenghtening be temporary as it was during our recent recession?)

Another question I have… My notion is that the dollar has been able to preserve its strength to some degree (while the fed continues to run the dollar printing press), because the dollar is used as the reserve currency of the world. If this next bubble pops, could we possibly see some dropping of the US dollar as a reserve currency (used to trade oil etc.), leading to more inflation?

I know some of these questions cannot be definitely answered, but I’d be interesting in hearing from a lot of you who obviously know a lot more about economics than I do.

Roubini looks at financial things as they are, it is no doubt that the whole financial market is similar ot a casino, and all the corrections or crashes only distribute wealth from weak, or not so clever to the strong,rich or clever, the sad thing is that the econemies of the world are also affected by it, because if somebody makes a million or billion on his gambling, with that million or billion he/she can buy goods and servives produced often by slave labour.All the Democracies of the world are not really Demcracies but Plutocracies and all the world leaders are too weak to change anything or are in bed with with the Plutocrats.